CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 72% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs, FX or any of our other products work and whether you can afford to take the high risk of losing your money. Losses can exceed deposits on some products.

USDCNH options in the event that CNY is on the move

Summary: As the US and China face off over trade policy issues, China may at some point choose to walk away from its commitment to maintain a floor under the renminbi versus the US dollar. Here we take a look at how to position for a larger USDCNY move, now that the exchange rate has pushed back close to what many perceive as the critical level of 7.00.

Important note: this article is not intended to promote the view that China will devalue its currency, rather merely an effort to discuss the possibly dynamics for trades that look for that eventuality in the event that it unfolds. The strong risk in any scenario around the situation is a) that it doesn’t happen at all and b) that it happens on a very different time frame and/or very slowly. In fact, if the market calms as the US and China head back to the negotiation table and the US Federal reserve swings into a more easy stance in line with its new attitude toward inflation, the US dollar might fall across the board, including against the CNY, which might then fall against other non-USD peers.

Near record low volatility has plagued trading conditions for currency traders in recent months, both in terms of the actual daily trading ranges and the general lack of sustained trending moves. One of the chief drivers of low volatility has been China’s policy of anchoring the CNY to a narrow trading range versus the US dollar and maintaining an assumed cap on USDCNY ahead of 7.00, all while US-China trade talks are ongoing. Given the recent escalation in the tone and conduct of the two sides, the question is more pressing than ever as the exchange rate has rapidly approached that 7.00 level again for only the third time since late 2016.

Here we aren’t going to argue about the probability or timing of an eventual move by China on its currency policy. We’re simply going to make the case that it is a possibility at any time and offer a bit of perspective on how the options market is priced for this eventuality in case traders would like to hedge or otherwise position for an outcome in which the CNY (and for our purposes, the offshore version of the CNY, the CNH) moves slightly or more significantly lower.

First, let’s have a look at why China might want to allow the CNY to weaken, followed by reasons China might be expected to maintain its current policy on the CNY

Reasons for China to allow CNY to fall:

•A weaker CNY would offset some of the sting of US tariffs as exports could be priced lower in USD terms to offset the tariffs. •The currency is “fundamentally” overvalued in inflation-adjusted terms if measured in a longer-term perspective and lower is the path of least resistance. •Allowing the currency to float more freely (to the downside) would give more leeway to provide more accommodative monetary policy if more stimulus is needed to offset growth risks from any trade policy showdown and to help deleverage the very leveraged corporate sector. •A more floating and market set currency after some initial volatility is a necessary step if China would like to deepen its capital markets and attract foreign capital as it transforms its economy to a more balanced approach. •The USD is strong and the history of the US dollar since the global financial crisis shows the dysfunctions that arise due to the USD being used as the world’s global reserve currency: liquidity traps develop for offshore countries whenever the US Fed is tightening policy and the US fiscal issuance rises. Allowing the USD to move higher might help usher a new mini-crisis that forces the US and the rest of the world to consider how to create an later (this is a very thorny, long-term subject, but one that will return again and again until some other asset is found to being replacing the US dollar, or at least reducing its use by China).

Reasons for China to maintain the floor under the CNY:

•Concern that a fall suggests a show of weakness and risks capital flight and financial and socioeconomic instability domestically that impacts the government’s mandate to deliver ever upwards growth and prosperity. •The loss of purchasing power means that the price of the commodities in China’s enormous import bill will rise. (Although one might argue that as China is such a large buyer of some commodities like iron ore, that those prices might adjust to reflect the weaker currency.) •This could be seen from the US side – fair or not – as a dramatic escalation in the ongoing showdown over trade, making coming to terms potentially that much more difficult to achieve.

So there are compelling reasons for both maintaining the status quo – especially as long as an eventual salvaging of the US-China trade talks is a priority – as well as compelling reasons for China to take the plunge and allow market forces to set the price for the renminbi. Then how to trade the weaker CNH outcome? Here are some ways traders can approach this:

Long USDCNH spot or forward: the most straightforward way to trade for a weaker CNY (or CNH in our case) is via a USDCNH spot or forward trade. The difficulty there is that China has at times in the past mobilised punitive swap rates to make holding such positions very expensive, as high swap rates can mean expensive rolling costs. That being said, the current swap rates as of this writing are negligible, even as USDCNH has risen above 6.90.

USDCNH call options: A long USDCNH call option is likely the “safest” way to trade for a weaker CNH, if only in terms of knowing the maximum downside risk on a straight, plain vanilla call option: the risk that an option expires worthless and all of the premium paid is lost. Some perspective on how USDCNH volatility is prices is shown in the chart below. Keep in mind that 3-month implied volatility, although it has risen considerably from recent lows

Below are a couple of ways to trade for a USDCNH move using 3-month options, which of course assume that something will unfold within a three-month time frame – longer dated options of six months or more are of course more expensive but offer more time for a situation to develop:

Trading for a more modest move:

The idea here is that USDCNH might move, but not necessarily by a significant amount – a few percent at most. A call spread is an approach that allows a lower breakeven on the option structure, though it can be more challenging to hedge, while a plain vanilla approach offers a more straightforward outcome and hedging can enhance the overall profitability of the option Long USDCNH call spread: The trade: Long 3-month (expiry Aug 21) USDCNH 7.05 call and short USDCNH 7.25 call Net cost: 0.0345 (spot ref 6.93 on May 21) Breakeven price: 7.0845 (spot moves about 2.2% higher from current 6.93 area) Maximum gain: 0.1655 at 7.25 (spot moves a bit over 4.5% from 6.93 area), or about 4.8x the amount of premium risked

Here the idea is to achieve significant leverage relative to the amount risk on upfront premium in the event a very large USDCNH move unfolds. The trade: Long 3-month (expiry Aug. 21) USDCNH 7.25 call Net cost: 0.0240 (spot ref 6.93 on May 21) Breakeven price: 7.274 (spot USDCNH moves about 5% higher from current 6.93) Maximum gain: no theoretical maximum. But example at 7.50 on expiry, profit is 9.4x the amount risked, and at 7.6 is over 13.5x amount of premium risked.

The unconventional trade: long USDHKD– this is a somewhat unconventional way to trade for a weaker CNH indirectly, as a loosening of the commitment to the CNY floor could also see a weakening of regional Asian currencies, and in that regard one of the most interesting exchange rates is US dollar versus the Hong Kong dollar, an exchange rate managed with a currency board arrangement by the Hong Kong Monetary Authority with the mandate to keep the exchange rate in a narrow 7.75-7.85 corridor that has been in operation since 1983. The idea here isn’t whether the HKMA is able to maintain the corridor, but whether it makes any sense longer to do so if the CNY moves significantly lower and takes much of the rest of Asia with it. Already, the 7.85 level has been tried multiple times late last year and this year – requiring significant intervention efforts to maintain.

The Trade: Long USDHKD at 7.85, stop below 7.80. This position pays modest carry to the trade as the USD short interest rate is higher than the HK rate. So if nothing happens and the spot stays near the current price, the trader walks away with a small profit. Of course, if the HKMA abandons the corridor and allows HKD to weaken, the position moves into more notable profit.

Chart: USDCNH versus 3-month implied volatility and the 25-delta and 10-delta options skew, which shows that traders looking for a large move have to pay significantly more in implied volatility terms, relative to the cost of puts – as the market assumes that if USDCNH is going to move a lot, it will be to the upside.

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Support CentreFor existing clients, please click here to request support via the Support Centre.

Have a question about our products, platforms or services? Visit the Support Centre to find answers for our most frequently asked questions. If you are still unable to locate an answer to your question, you will also find contact details for your local Saxo office to speak with a representative.

General

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 72% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs, or any of our other products work, and whether you can afford to take the high risk of losing your money. The value of your investments can go down as well as up. Losses can exceed deposits on some margin products. Professional clients can lose more than they deposit. All trading carries risk.

Trade Responsibly All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more Additional Key Information Documents are available in our trading platform.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo Markets assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.

X

Your browser cannot display this website correctly.

Our website is optimised to be browsed by a system running iOS 9.X and on desktop IE 10 or newer. If you are using an older system or browser, the website may look strange. To improve your experience on our site, please update your browser or system.